Clayton Christensen: How Pursuit of Profits Kills Innovation and the U.S. Economy

"Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

John Maynard Keynes

In an interesting talk at the Gartner Symposium ITExpo 2011 on October 16-20, 2011, Clayton Christensen explains why the basic thinking taught in business schools and promulgated by consultants is killing innovation and the US economy. The talk is available here.

How whole sectors of the economy are dying

Christensen retells the story of how Dell [DELL] progressively lopped off low-value segments of its PC operation to the Taiwan-based firm ASUSTek [LSE: ASKD]—the motherboard, the assembly of the computer, the management of the supply chain and finally the design of the computer. In each case Dell accepted the proposal because in each case its profitability improved: its costs declined and its revenues stayed the same. At the end of the process, however, Dell was little more than a brand, while ASUSTeK can—and does—now offer a cheaper, better computer to Best Buy at lower cost.

Christensen also describes the impact of foreign outsourcing on many other companies, including the steel companies, the automakers, the oil companies, the pharmaceuticals, and now even software development. These firms are steadily becoming primarily marketing agencies and brands: they are lopping off the expertise that is needed to make anything anymore. In the process, major segments of the US economy have been lost, in some cases, forever.

Business school thinking is driving this

Why is this happening? According to Christensen, the phenomenon is being

“driven by the pursuit of profit. That’s the causal mechanism for these things… The problem lies with the business schools which are at fault. What we’ve done in America is to define profitability in terms of percentages. So if you can get the percentage up, it feels like we are more profitable. It causes us to do things to manipulate the percentage. I’ll give you a few examples.

There is a pernicious methodology for calculating the internal rate of return on an investment. It causes you to focus on smaller and smaller wins. Because if you ever use your money for something that doesn’t pay off for years, the IRR is so crummy that people who focus on IRR focus their capital on shorter and shorter term wins.

There’s another one called RONA—rate of return on net assets. It causes you to reduce the denominator—assets—as Dell did, because the fewer the assets, the higher the RONA.

“We measure profitability by these ratios. Why do we do it? The finance people have preached this almost like a gospel to the rest of us is that if you describe profitability by a ratio so that you can compare profitability in different industries. It ‘neutralizes’ the measures so that you can apply them across sectors to every firm.”

The thinking is systematically taught in business and followed by Wall Street analysts. Christensen even suggests that in slavishly following such thinking, Wall Street analysts have outsourced their brains.

"They still think they are in charge, but they aren’t. They have outsourced their brains without realizing it. Which is a sad thing."

The case of the semi-conductor industry

How is this working out across the economy? In the semi-conductor industry, for instance, there are almost no companies left in America that fabricate their own products besides Intel [INTC]. Most of them have become “fab-less” semiconductor companies. These companies are even proud of being “fab-less” because their profit as a percent of assets is much higher than at Intel. So they outsource the fabrication of the semi-conductors to Taiwan and China.

Christensen notes that when he visits these these factories, they have nothing to do with cheap labor. It's very sophisticated manufacturing, even though it’s (not yet) design technology. The plants cost around 10 billion dollars to build.

Christensen recalls an interesting talk he had with the Morris Chang the chairman and founder of one of the firms, TSMC [TSM], who said:

“You Americans measure profitability by a ratio. There’s a problem with that. No banks accept deposits denominated in ratios. The way we measure profitability is in ‘tons of money’. You use the return on assets ratio if cash is scarce. But if there is actually a lot of cash, then that is causing you to economize on something that is abundant.”

Christensen agrees. He believes that the pursuit of profit, as calculated by the ratios like IRR and ROA, is killing innovation and our economy. It is the fundamental thinking drives that decisions that he believes are "just plain wrong".

Can IRR be defended?

A case could be made that it is wrong to blame the analytic tools, IRR and RONA, rather than the way that the tools being used.

Thus when a firm calculates the rate of return on a proposal to outsource manufacturing overseas, it typically does not include:

The cost of the knowledge that is being lost, possibly forever.

The cost of being unable to innovate in future, because critical knowledge has been lost.

The consequent cost of its current business being destroyed by competitors emerging who can make a better product at lower cost.

The missed opportunity of profits that could be made from innovations based on that knowledge that is being lost.

The calculation of the IRR based on a narrow view of costs and benefits assumes that the firm’s ongoing business will continue as is, ad infinitum. The narrowly-defined IRR thus misses the costs and benefits of the actions that it is now taking that will systematically destroy the future flow of benefits. The use of IRR with the full costs and benefits included would come closer to revealing the true economic disaster that is unfolding.

The way to continuous innovation and sustainable economic growth

Although the use of the tools could be improved, the IRR and ROA do tend to imply a static external environment, at a time when the external environment is highly dynamic. Businesses that exist today may be gone tomorrow. To survive in this world, a different kind of mindset is needed.

In this new world, the bottom of line of business isn’t profits but rather customer delight, i.e. the provision of a continuous stream of additional value to customers and delivering it sooner. As a result of epochal shift of power in the marketplace from seller to buyer, the customer is now in charge. We now live in the age of customer capitalism. Making money and corporate survival now depend not merely on pushing products at customers but rather on delighting them so that they want to keep on buying. To prosper, firms must have knowledge workers who are continuously innovating and delivering a steady supply of new value to customers and delivering it sooner.

Focusing everyone in the organization on delivering additional value to customers is what gives a firm resilience. As a result, as Ranjay Gulati explains in his book, Reorganize for Resilience (HBP, 2010), the firm’s goal has to become one of serving customers: i.e. a shift from inside-out perspective (“You take what we make”) to an outside-in perspective (“We seek to understand your problems and will surprise you by solving them”). The purpose of a firm is to serve its clients and its bottom line become: are the customers delighted?

Firms need to be evaluating future investments strategically in terms of how they will affect their capacity to go on delighting their customers for a sustained period in the future.

For managers trained in traditional business school thinking, the idea that pursuit of profit is the problem, rather than the solution to the economy’s problems, may come as a shock. For business school professors who have spent their lives teaching the focus on profits and the use of IRR and RONA to measure profits, the coming change may be even more disturbing.

Like all new ideas, in the first instance it will be rejected. Then it will be ridiculed. Finally it will be self-evident and no one will be able to remember why anyone ever thought otherwise.